March 14, 2010

Expect to See a Big Fight on Bank Capital

The sharp rise in financial stocks suggests investors believe big banks are done raising large amounts of fresh capital to strengthen their balance sheets. But international bank regulators, with the blessing of national overseers, are readying rule changes that could further increase the amount of capital banks hold, especially in their trading operations.

In recent weeks, Wall Street analysts have started to guess what this extra capital burden could be—and the numbers are surprisingly large. This should give bank investors pause: The stocks are a good buy if the economy continues to recover, but, if the rule changes are tough, shareholders could face yet more dilution.

A dearth of capital was one reason banks were so shaky going into the financial crisis. In response, banks were forced into substantial capital raisings. But the industry had little reason to complain.

For instance, at the end of 2007, shareholders equity, one measure of capital, was equivalent to a mere 3% of assets at Morgan Stanley and 3.8% at Goldman Sachs Group. A combination of equity raises and asset reductions hoisted that ratio to 6.1% at the end of 2009 at Morgan Stanley, and to 8.3% at Goldman. In 2008 and 2009, a whopping $250 billion was raised by Goldman, Morgan Stanley, Citigroup, J.P. Morgan Chase, Bank of America and Wells Fargo, according to Dealogic. This counts common, preferred and convertible stock and excludes government equity injections that have been repaid.

So why would banks now need more? Partly to comply with changes to Basel II, a bank regulatory framework that advanced countries have implemented, or are in the process of adopting. And it is the banks with large trading books that have most to fear, as the new rules aim to substantially strengthen buffers for instruments such as derivatives and asset-backed securities.

Goldman analysts recently put the cat among the pigeons by estimating what the Basel II amendments could do to capital held against credit derivatives. In a highly theoretical scenario, Goldman said Morgan Stanley might need to hold $269 billion of regulatory capital against its credit derivatives book, BofA $108 billion and J.P. Morgan $21 billion. Applying an approximation of Goldman’s analysis to itself suggests the firm would need about $100 billion against its credit derivatives.

Given that Goldman has $65 billion of Tier 1 regulatory capital, it seems unlikely that it would have to hold $100 billion against just its credit derivatives. And Morgan Stanley says it “strongly disputes both the methodology and the capital conclusion reached in the Goldman report.”

At the very least, the Goldman analysis is a reminder that large pockets of under-capitalization may still exist. Indeed, while banks may dispute specific scenarios, they readily recognize that the Basel II changes would lead to big increases in “risk-weighted assets.” This would drive up the dollar amount of capital needed, because capital requirements are set as a percentage of risk-weighted assets.

Of course, the banks will try hard to push back against these changes. Their pressure has already helped water down the financial overhaul going through Congress.

Then again, Basel II’s revamped capital requirements, rather than rules that require law makers’ approval, might be the best way to reduce risk in the system. The Basel rules are internationally applied and are implemented by bank regulators, which should be immune to political interference.

The real reform of Wall Street could originate not on Capitol Hill, but in a sleepy Swiss town.